The coronavirus, fat tails and investment strategy

One of the less conventional measures of portfolio risk is whether an investor sleeps well. There are two schools of thought. One is that risk is well-managed when sleep is undisturbed. The other is that sleeping soundly is a sure sign that a portfolio is too low risk.

Whichever view an investor favours, it is tail-risk that most disturbs investors, even if they are unaware of the term. Tail risk refers to larger than usual market moves.

The huge potential rewards of investing, and the vast sums involved, see a lot of mathematical talent applied to developing better market theory. The volatility of a share, an index or a currency is an important measure of the risk of that instrument. Volatilities are calculated by looking at the way (usually) daily returns are distributed.

For a share the daily return is the difference between yesterday’s closing price and today’s close, divided by yesterday’s price. The daily return is positive or negative percentage, depending on whether the share rose or fell. A quantitative analyst takes each daily return for (say) the last year, and puts them on a scale. The average is calculated, and each daily return is compared to that average.

The distance from the average of any given return is calculated in standard deviations. The higher the deviation, the greater the difference between that day’s move and the average.

In a normal distribution 99.7% of results fall within three standard deviations of the average. However analysis from around the globe shows that share and index return distributions have “fat-tails”. That is they have more shock events, generating bigger than expected price moves, than a mathematician would expect.

The higher risk exposed by fat tails can be positive. Takeovers, short squeezes and melt-ups are examples. These rarely cause investor concern. It’s the negative risk events that keep investors tossing and turning. The recent outbreak of a newly discovered coronavirus in China is a good example. Growth exposed markets are slumping. Shares, crude oil, and base metals prices are dropping rapidly, and volatility (and risks) generally higher.

Markets move most on surprises. By definition, surprises are unpredictable. Analysts burnt a lot of electrons on market outlook analysis as 2019 became 2020. Not many (none?) discussed the market risk of a viral outbreak.

The facts that surprises move markets most, and are unpredictable, gives the first clue on how investors can manage tail risks. Investors should expect that negative market events will arise without warning, and incorporate this in their investment strategy.

Many tools are available to help investors manage their risk. The right approach depends on an investor’s individual circumstances, and not every approach is suitable for every investor. Investors taken by surprise by this week’s moves may consider a number of options to reduce tail risk.

Diversification is a powerful risk reduction tool available to all. While the viral outbreak is putting pressure on growth-exposed assets, safe havens like bonds and gold are rallying. Investors seeking longer-term stability in their portfolio could include these types of assets in their portfolio. This usually means lower longer-term returns as well, and investors must decide for themselves whether stability or returns are more important.

There are many other possible responses to the market facts of life. Building lower beta portfolios, using dividend “floors”, hedging portfolios with put options or short index CFD positions all deliver when share markets are under pressure. A number of investors did well last year with a strategy of staying in cash and buying call options to hedge the risk of a strong market rise.

Whatever the approach the most important factor is preparing ahead of time for the outrageous slings and arrows of markets. Uncertain investors should seek independent advice. Those who fail to plan ahead leave themselves vulnerable to two factors that can be very damaging to wealth; panic and despair.

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